Chapter 14 The Cost of Capital

1. Chapter 14The Cost of Capital

2. Slide Contents • Principles Applied in This Chapter • Learning Objectives • The Cost of Capital: An Overview • Determining the Firm’s Capital Structure Weights • Estimating the Cost of Individual Sources of Capital

3. Slide Contents (cont.) • Summing Up: Calculating the Firm’s WACC • Estimating Project Costs of Capital • Floatation costs and Project NPV • Key Terms

4. Learning Objectives • Understand the concepts underlying the firm’s overall cost of capital and the purpose for its calculation. • Evaluate a firm’s capital structure, and determine the relative importance (weight) of each source of financing. • Calculate the after-tax cost of debt, preferred stock, and common equity.

5. Learning Objectives (cont.) • Calculate a firm’s weighted average cost of capital. • Discuss the pros and cons of using multiple, risk-adjusted discount rates. Describe the divisional cost of capital as a viable alternative for firms with multiple divisions. • Adjust NPV for the costs of issuing new securities when analyzing new investment opportunities.

6. Principles Applied in This Chapter • Principle 1: Money Has a Time Value. • Principle 2: There is a Risk-Return Tradeoff. • Principle 3: Cash Flows Are the Source of Value. • Principle 4: Market Prices Reflect Information. • Principle 5: Individuals Respond to Incentives.

7. 14.1 The Cost of Capital: An Overview

8. The Cost of Capital: An Overview • A firm’s Weighted Average Cost of Capital, or WACC is the weighted average of the required returns of the securities that are used to finance the firm. • WACC incorporates the required rates of return of the firm’s lenders and investors and also accounts for the the particular mix of financing.

9. The Cost of Capital: An Overview (cont.) The riskiness of a firm affects its WACC as: • required rate of return on securities will be higher if the firm is riskier, and • risk will influence how the firm chooses to finance i.e. proportion of debt and equity.

10. The Cost of Capital: An Overview (cont.) WACC is useful in a number of settings: • WACC is used to value the entire firm. • WACC is often used for determining the discount rate for investment projects • WACC is the appropriate rate to use when evaluating firm performance

11. WACC equation

12. Figure 14.1 A Template for Calculating WACC

13. Three Step Procedure for Estimating Firm WACC • Define the firm’s capital structure by determining the weight of each source of capital. (see column 2, figure 14-1) • Estimate the opportunity cost of each source of financing. These costs are equal to the investor’s required rates of return.(see column 3, figure 14-1)

14. Three Step Procedure for Estimating Firm WACC (cont.) • Calculate a weighted average of the costs of each source of financing. This step requires calculating the product of the after-tax cost of each capital source used by the firm and the weight associated with each source. The sum of these products is the WACC. (see column 4, figure 14-1)

15. 14.2 DETERMINING THE FIRM’S CAPITAL STRUCTURE WEIGHTS

16. Determining the Firm’s Capital Structure Weights The weights are based on the following sources of financing: debt (short-term and long-term), preferred stock and common equity. Liabilities such as accounts payable are not included in capital structure.

17. Determining the Firm’s Capital Structure Weights (cont.) • In theory, market value is preferred for all securities. However, not all market values may be readily available. • In practice, we generally use book values for debt and market values for equity securities.

18. Calculating the WACC CHECKPOINT 14.1: CHECK YOURSELF

19. The Problem After completing her estimate of Templeton’s WACC, the CFO decided to explore the possibility of adding more low-cost debt to the capital structure. With the help of the firm’s investment banker, the CFO learned that Templeton could probably push its use of debt to 37.5% of the firm’s capital structure by issuing more debt and retiring (purchasing) the firm’s preferred shares. This could be done without increasing the firm’s costs of borrowing or the required rate of return demanded by the firm’s common stockholders. What is your estimate of the WACC for Templeton under this new capital structure proposal?

20. Step 1: Picture the Problem

21. Step 1: Picture the Problem (cont.)

22. Step 2: Decide on a Solution Strategy We need to determine the WACC based on the given information: • Weight of debt = 37.5%; Cost of debt = 6% • Weight of common stock = 62.5%; Cost of common stock =15%

23. Step 2: Decide on a Solution Strategy (cont.) We can compute the WACC based on the following equation:

24. Step 3: Solve The WACC is equal to 11.625% as calculated below.

25. Step 4: Analyze We observe that as Templeton chose to increase the level of debt to 37.5% and retire the preferred stock, the WACC decreased marginally from 12.125% to 11.625%. Thus altering the weights will change the WACC.

26. 14.3 Estimating the Cost of Individual Sources of Capital

27. The Cost of Debt The cost of debt is the rate of return the firm’s lenders demand when they loan money to the firm. We estimate the market’s required rate of return on a firm’s debt using its yield to maturity and not the coupon rate.

28. The Cost of Debt (cont.) After-tax cost of debt = Yield (1-tax rate) • Example What will be the yield to maturity on a debt that has par value of $1,000, a coupon interest rate of 5%, time to maturity of 10 years and is currently trading at $900? What will be the cost of debt if the tax rate is 30%?

29. The Cost of Debt (cont.) Enter: • N = 10; PV = -900; PMT = 50; FV =1000 • I/Y = 6.38% • After-tax cost of Debt = Yield (1-tax rate) = 6.38 (1-.3) = 4.47%

30. The Cost of Debt (cont.) It is not easy to find the market price of a specific bond. It is a standard practice to estimate the cost of debt using yield to maturity on a portfolio of bonds with similar credit rating and maturity as the firm’s outstanding debt.

31. Figure 14-2 A Guide to Corporate Bond Ratings

32. Figure 14-3 Corporate Bond Yields: Default Ratings and Term to Maturity

33. The Cost of Preferred Equity The cost of preferred equity is the rate of return investors require of the firm when they purchase its preferred stock.

34. The Cost of Preferred Equity (cont.) Example The preferred shares of Relay Company that are trading at $25 per share. What will be the cost of preferred equity if these stocks have a par value of $35 and pay annual dividend of 4%? Using equation 14-2a kps = $1.40 ÷ $25 = .056 or 5.6%

35. The Cost of Common Equity The cost of common equity is the rate of return investors expect to receive from investing in firm’s stock. This return comes in the form of dividends and proceeds from the sale of the stock). There are two approaches to estimating the cost of equity: • The dividend growth model (from chapter 10) • CAPM (from chapter 8)

36. The Dividend Growth Model – Discounted Cash Flow Approach • Estimate the expected stream of dividends that the common stock is expected to provide. • Using these estimated dividends and the firm’s current stock price, calculate the internal rate of return on the stock investment.

37. The Dividend Growth Model – Discounted Cash Flow Approach

38. Estimating the Cost of Common Equity CHECKPOINT 14.2: CHECK YOURSELF

39. The Problem Prepare two additional estimates of Pearson’s cost of common equity using the dividend growth model where you use growth rates in dividends that are 25% lower than the estimated 6.25% (i.e., for g equal to 4.69% and 7.81%)

40. Step 1: Picture the Problem We are given the following: • Price of common stock (Pcs ) = $19.39 • Growth rate of dividends (g) = 4.69% and 7.81% • Dividend (D0) = $0.49 per share • Cost of equity is given by dividend yield + growth rate.

41. Step 1: Picture the Problem (cont.) Dividend Yield =D1 ÷ P0 Growth Rate (g) Cost of Equity (kcs )

42. Step 2: Decide on a Solution Strategy We can determine the cost of equity using equation 14-3a

43. Step 3: Solve At growth rate of 4.69% kcs = {$0.49(1.0469)/$19.39} + .0469 = .0733 or 7.33% At growth rate of 7.81% kcs = {$0.49(1.0781)/$19.39} + .0781 = .1053 or 10.53 %

44. Step 4: Analyze • Pearson’s cost of equity is estimated at 7.33% and 10.53% based on the different assumptions for growth rate. • Thus growth rate is an important variable in determining the cost of equity. However, estimating the growth rate is not easy.

45. Estimating the Rate of Growth, g The growth rate can be obtained from: • websites that post analysts forecasts, and • using historical data to compute the arithmetic average or geometric average.

46. Estimating the Rate of Growth, g (cont.)

47. Pros and Cons of the Dividend Growth Model Approach • Pros – easy to use • Cons – severely dependent upon the quality of growth rate estimates, unrealistic assumption about constant dividend growth rate

48. The Capital Asset Pricing Model CAPM (from chapter 8) was designed to determine the expected or required rate of return for risky investments.

49. The Capital Asset Pricing Model (cont.) Equation 14-4 illustrates that the expected return on common stock is determined by three key ingredients: • The risk-free rate of interest, • The beta of the common stock returns, and • The market risk premium.

50. Advantages and Disadvantages of the CAPM approach Pros – easy to use, does not depend on dividend o growth assumptions. Cons – Choice of risk-free is not clearly defined, estimates of beta and market risk premium will vary depending on the data used.